Derivatives as Risk Management Tool for Corporates

7/27/2019 Derivatives as Risk Management Tool for Corporates

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Preface

This paper examines the different Derivatives instrumentsthat are being used by corporate to hedge their risk. The

economic climate and markets can be affected very quickly by

changes in exchange rates, interest rates, and commodity prices.

Counterparties can rapidly become problematic. As a result, it is

important to ensure financial risks are identified and managed

appropriately. The financial markets have created their own way

of offering insurance against financial loss in the form of contracts

called derivatives. It is necessary for the corporate to have fairestimate of the risk they will run into if conditions become

unfavorable. One of the methods of identifying the Value at Risk

(VaR) is Monte Carlo Simulation.

The study is a sincere effort to understand these problems,

analyze them and suggest ways to eliminate the same.


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Derivatives as Risk Management Tool for Corporates

Derivatives as a Risk ManagementTool for Corporate

Table of ContentsTable of Contents.......................................................................................................2

1.Introduction............................................................................................................. 4

1.1 Factors that Impact Financial Rates and Prices.................................................6

1.2 Factors that Affect Interest Rates......................................................................6

1.3 Factors that Affect Foreign Exchange Rates......................................................6

1.4 Factors that Affect Commodity Prices...............................................................7

1.5 Transaction Exposure........................................................................................ 9

1.6 Translation Exposure.........................................................................................9

1.7 Foreign Exchange Exposure from Commodity Prices......................................10

1.8 Strategic Exposure..........................................................................................10

1.9 Commodity Risk..............................................................................................11

1.10 Credit Risk.....................................................................................................11

1.11 Operational Risk............................................................................................ 12

1.12 Derivatives.................................................................................................... 121.12.1 FORWARDS .............................................................................................13

1.12.2 Contingent Claims .................................................................................. 14

1.13 Indian Accounting Practices...........................................................................16

1.13.1 Foreign Exchange Forwards....................................................................16

1.13.2 Accounting of Index Futures....................................................................16

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1.13.3 Regulatory Framework............................................................................ 17

1.13.4 Daily Mark to Market...............................................................................18

1.13.5 Recognition of Profit or Loss....................................................................18

1.13.5 Accounting at Financial Year End............................................................19

1.13.6 Accounting for Derivatives as per FAS 133.............................................19

1.13.7 Derivatives used as hedging instruments...............................................20

1.13.8 Hedge Recognition ................................................................................. 20

1.14 Indian Market................................................................................................21

2.0 Review of Literature...........................................................................................24

3.0 Data and Methodology.......................................................................................29

3.1 Data.................................................................................................................29

3.2 Methodology....................................................................................................31

4.0 Analysis and Interpretation.................................................................................33

4.1 Manufacturing Industry...................................................................................33

4.1.1 Buyers Credit.............................................................................................33

4.1.2 Commodities Contract (Gain/Loss)............................................................36

4.1.3 Export Earnings......................................................................................... 40

4.1.4 Investments..............................................................................................41

4.2 Banking Sector................................................................................................ 44

4.2.1 Forex Transactions.................................................................................... 444.2.2 Currency Swaps.........................................................................................47

4.2.3 Investments..............................................................................................49

4.2.4 Borrowings................................................................................................ 51

4.2.5 Deposits.................................................................................................... 53

4.2.6 Credit Exposure Overseas.......................................................................55

4.2.7 Credit Exposure Domestic.........................................................................58

4.2.7 Currency Derivatives.................................................................................60

4.2.8 Interest Rate Derivative Assets.................................................................63

5.0 Main Findings/Inference......................................................................................64

6.0 Scope of Further Research.................................................................................64

7.0 Conclusion..........................................................................................................65

8.0 Bibliography.......................................................................................................66

9.0 Appendix............................................................................................................ 67

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1.IntroductionAlthough financial risk has increased significantly in recent

years, risk and risk management are not contemporary issues.

The result of increasingly global markets is that risk may originate

with events thousands of miles away that have nothing to do with

the domestic market. Information is available instantaneously,

which means that change, and subsequent market reactions,

occur very quickly.

The economic climate and markets can be affected very

quickly by changes in exchange rates, interest rates, andcommodity prices. Counterparties can rapidly become

problematic. As a result, it is important to ensure financial risks

are identified and managed appropriately.

Risk refers to the probability of loss, while exposure is the

possibility of loss, although they are often used interchangeably.

Risk arises as a result of exposure. Exposure to financial markets

affects most organizations, either directly or indirectly. When an

organization has financial market exposure, there is a possibilityof loss but also an opportunity for gain or profit. Financial market

exposure may provide strategic or competitive benefits. Risk is

the likelihood of losses resulting from events such as changes in

market prices. Identifying exposures and risks forms the basis for

an appropriate financial risk management strategy.

Financial risk arises through countless transactions of a

financial nature, including sales and purchases, investments and

loans, and various other business activities. It can arise as a result

of legal transactions, new projects, mergers and acquisitions, debt

financing, the energy component of costs, or through the

activities of management, stakeholders, competitors, foreign

governments, or weather.

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When financial prices change dramatically, it can increase

costs, reduce revenues, or otherwise adversely impact the

profitability of an organization. Financial fluctuations may make it

more difficult to plan and budget, price goods and services, and

allocate capital.

There are three main sources of financial risk:

Financial risks arising from an organizations exposure to

changes in market prices, such as interest rates, exchange

rates, and commodity prices

Financial risks arising from the actions of, and transactions

with, other organizations such as vendors, customers, andcounterparties in derivatives transactions

Financial risks resulting from internal actions or failures of

the organization, particularly people, processes, and systems

Financial risk management deals with the uncertainties

resulting from financial markets. It involves assessing the

financial risks facing an organization and developing management

strategies consistent with internal priorities and policies.

Addressing financial risks proactively provides an organization

with a competitive advantage. It also ensures that management,

operational staff, stakeholders, and the board of directors are in

agreement on key issues of risk. The passive strategy of taking no

action is the acceptance of all risks by default. Organizations

manage financial risk using a variety of strategies and products.

Strategies for risk management often involve derivatives.

There are three broad alternatives for managing risk:

Do nothing and actively, or passively by default, accept all

risks.

Hedge a portion of exposures by determining which

exposures can and should be hedged.

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Hedge all exposures possible.

1.1 Factors that Impact Financial Rates and Prices

Financial rates and prices are affected by a number of

factors, in turn; impact the potential risk of an organization.

1.2 Factors that Affect Interest Rates

Interest rates are a key component in many market prices

and an important economic barometer. They are comprised of the

real rate plus a component for expected inflation, since inflationreduces the purchasing power of a lenders assets. Interest rates

are also reflective of supply and demand for funds and credit risk.

Interest rates are particularly important to companies and

governments because they are the key ingredient in the cost of

capital.

Factors that influence the level of market interest rates include:

Expected levels of inflation General economic conditions

Monetary policy and the stance of the central bank

Foreign exchange market activity

Foreign investor demand for debt securities

Levels of sovereign debt outstanding

Financial and political stability

1.3 Factors that Affect Foreign Exchange Rates

Foreign exchange rates are determined by supply and

demand for currencies. Supply and demand, in turn, are

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influenced by factors in the economy, foreign trade, and the

activities of international investors. Capital flows, given their size

and mobility, are of great importance in determining exchange

rates.

Some of the key drivers that affect exchange rates include:

Interest rate differentials net of expected inflation

Trading activity in other currencies

International capital and trade flows

International institutional investor sentiment

Financial and political stability

Monetary policy and the central bank

Domestic debt levels (e.g., debt-to-GDP ratio)

Economic fundamentals

1.4 Factors that Affect Commodity Prices

Physical commodity prices are influenced by supply and

demand. Unlike financial assets, the value of commodities is also

affected by attributes such as physical quality and location.

Commodity supply is a function of production. Supply may be

reduced if problems with production or delivery occur, such as

crop failures or labor disputes. In some commodities, seasonal

variations of supply and demand are usual and shortages are not

uncommon. Demand for commodities may be affected if final

consumers are able to obtain substitutes at a lower cost. There

may also be major shifts in consumer taste over the long term if

there is supply or cost issues.

Commodity prices may be affected by a number of factors,

including:

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Expected levels of inflation, particularly for precious metals

Interest rates

Exchange rates, depending on how prices are determined

General economic conditions

Costs of production and ability to deliver to buyers

Availability of substitutes and shifts in taste and

consumption patterns

Weather, particularly for agricultural commodities and

energy

Political stability, particularly for energy and precious metals

Major market risks arise out of changes to financial market

prices such as exchange rates, interest rates, and commodity

prices. Major market risks are usually the most obvious type of

financial risk that an organization faces. Major market risks

include:

Foreign exchange risk Interest rate risk

Commodity price risk

Equity price risk

Other important related financial risks include:

Credit risk

Operational risk

Liquidity risk

Systemic risk

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The interactions of several risks can alter or magnify the potential

impact to an organization.

Risks faced by an organization can be broadly classified as

1.5 Transaction Exposure

Transaction risk impacts an organizations profitability

through the income statement. It arises from the ordinary

transactions of an organization, including purchases from

suppliers and vendors, contractual payments in other currencies,

royalties or license fees, and sales to customers in currencies

other than the domestic one. Organizations that buy or sell

products and services denominated in a foreign currency typically

have transaction exposure.

1.6 Translation Exposure

Translation risk traditionally referred to fluctuations that

result from the accounting translation of financial statements,

particularly assets and liabilities on the balance sheet. Translation

exposure results wherever assets, liabilities, or profits are

translated from the operating currency into a reporting currency.

Translation exposure affects an organization by affecting thevalue of foreign currency balance sheet items such as accounts

payable and receivable, foreign currency cash and deposits, and

foreign currency debt. Longer-term assets and liabilities, such as

those associated with foreign operations, are likely to be

particularly impacted.

Foreign currency debt can also be considered a source of

translation exposure. If an organization borrows in a foreign

currency but has no offsetting currency assets or cash flows,

increases in the value of the foreign currency vis--vis the

domestic currency mean an increase in the translated market

value of the foreign currency liability.

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1.7 Foreign Exchange Exposure from Commodity Prices

Since many commodities are priced and traded

internationally in U.S. dollars, exposure to commodities prices

may indirectly result in foreign exchange exposure for non-U.S.

organizations. Even when purchases or sales are made in the

domestic currency, exchange rates may be embedded in, and a

component of, the commodity price. In most cases, suppliers of

commodities, like any other business, are forced to pass along

changes in the exchange rate to their customers or suffer losses

themselves.

By splitting the risk into currency and commodity

components, an organization can assess both risks independently,determine an appropriate strategy for dealing with price and rate

uncertainties, and obtain the most efficient pricing. Protection

through fixed rate contracts that provide exchange rate

protection is beneficial if the exchange rate moves adversely.

However, if the exchange rate moves favorably, the buyer might

be better off without a fixed exchange rate.

1.8 Strategic Exposure

The location and activities of major competitors may be an

important determinant of foreign exchange exposure. Strategic or

economic exposure affects an organizations competitive position

as a result of changes in exchange rates. Economic exposures,

such as declining sales from international customers, do not show

up on the balance sheet, though their impact appears in income

statements.

The prices of goods exported by the firms competitors, whoare coincidentally located in a weak-currency environment,

become cheaper by comparison without any action on their part.

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1.9 Commodity Risk

Exposure to absolute price changes is the risk of commodity

prices rising or falling. Organizations that produce or purchase

commodities, or whose livelihood is otherwise related to

commodity prices, have exposure to commodity price risk.

Some commodities cannot be hedged because there is no

effective forward market for the product. Generally, if a forward

market exists, an options market may develop, either on an

exchange or among institutions in the over-the-counter market.

1.10 Credit Risk

Credit risk is one of the most prevalent risks of finance andbusiness. In general, credit risk is a concern when an organization

is owed money or must rely on another organization to make a

payment to it or on its behalf. The failure of counterparty is less of

an issue when the organization is not owed money on a net basis,

although it depends to a certain degree on the legal environment

and whether funds are owed on a net or aggregate basis on

individual contracts.

Credit risk increases as time to expiry, time to settlement, ortime to maturity increase. The move by international regulators to

shorten settlement time for certain types of securities trades is an

effort to reduce systemic risk, which in turn is based on the risk of

individual market participants. It also increases in an environment

of rising interest rates or poor economic fundamentals.

Organizations are exposed to credit risk through all business and

financial transactions that depend on the payment or fulfillment

of obligations of others. Credit risk that arises from exposure tocounterparty, such as in a derivatives transaction, is often known

as counterparty risk.

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1.11 Operational Risk

Operational risk arises from human error and fraud,

processes and procedures, and technology and systems.

Operational risk is one of the most significant risks facing an

organization because of the varied opportunities for losses to

occur and the fact that losses may be substantial when they

occur.

1.12 Derivatives

The financial markets have created their own way of offering

insurance against financial loss in the form of contracts called

derivatives. A derivative is a financial instrument that offers a

return based on the return of some other underlying asset. Itsreturn is derived from another instrument.

As the definition states, a derivative's performance is based

on the performance of an underlying asset. It trades in a market

in which buyers and sellers meet and decide on a price; the seller

then delivers the asset to the buyer and receives payment. The

price for immediate purchase of the underlying asset is called the

cash price or spot price. A derivative also has a defined and

limited life. A derivative contract initiates on a certain date and

terminates on a later date. Often the derivative's payoff is

determined are made on the expiration date, although that is not

always the case.

Derivative contracts can be classified into two general categories:

Forward Commitments

Contingent Claims

Within the category of forward commitments, two major

classifications exist:

Exchanged-traded contracts, specifically futures

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Over-the-counter contracts ( forward contracts and swaps)

1.12.1 FORWARDS

The forward contract is an agreement between two parties in

which one party, the buyer, agrees to buy from the other party,the seller, an underlying asset at a future date at a price

established at the start. The parties to the transaction specify the

forward contract's terms and conditions, such as when and where

delivery will take place and the precise identity of the underlying.

Each party is subject to the possibility that the other party will

default. These contracts call for the purchase and sale of an

underlying asset at a later date. The underlying asset could be a

security (i.e., a stock or bond), a foreign currency, a commodity,or combinations thereof, or sometimes an interest rate. The

forward market is a private and largely unregulated market. Any

transaction involving a commitment between two parties for the

future purchase or sale of an asset is a forward contract.

A Futures contractis a variation of a forward contract that

has essentially the same basic definition but some additional

features that clearly distinguish it from a forward contract. A

futures contract is not a private and customized transaction.Instead, it is a public, standardized transaction that takes place

on a futures exchange.

A futures exchange, like a stock exchange, is an organization

that provides a facility for engaging in futures transactions and

establishes a mechanism through which parties can buy and sell

these contracts. The contracts are standardized, which means

that the exchange determines the expiration dates, the

underlying, how many units of the underlying are included in one

contract, and various other terms and conditions.

Another important distinction between forward contracts and

futures contracts lies in the ability to engage in offsetting

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transactions. Forward contracts are generally designed to be held

until expiration.

A Swap is a variation of a forward contract that is essentially

equivalent to a series of forward contracts. Specifically, a swap isan agreement between two parties to exchange a series of future

cash flows. One party agrees to pay the other a series of cash

flows whose value will be determined by the unknown future

course of some underlying factor, such as an interest rate,

exchange rate, stock price, or commodity price. The other party

promises to make a series of payments that could also be

determined by a second unknown factor or, alternatively, could

be preset.

Swaps, like forward contracts, are private transactions and

thus not subject to direct regulation. Swaps are arguably the most

successful of all derivative transactions. Probably the most

common use of a swap is a situation in which a corporation,

currently borrowing at a floating rate, enters into a swap that

commits it to making a series of interest payments to the swap

counterparty at a fixed rate, while receiving payments from the

swap counterparty at a rate related to the floating rate at which itis making its loan payments. The floating components cancel,

resulting in the effective conversion of the original floating-rate

loan to a fixed-rate loan.

1.12.2 Contingent Claims

Contingent claims are derivatives in which the payoffs occur

if a specific event happens referred as options. An option is a

financial instrument that gives one party the right, but not the

obligation, to buy or sell an underlying asset from or to another

party at a fixed price over a specific period of time. An option that

gives the right to buy is referred to as a call; an option that gives

the right to sell is referred to as a put. The fixed price at which

the underlying can be bought or sold is called the exercise price,

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strike price, striking price, or strike, and is determined at the

outset of the transaction.

The payoff of the option is contingent on an event taking

place. In contrast to participating in a forward or futures contract,which represents a commitment to buy or sell, owning an option

represents the right to buy or sell. To acquire this right, the buyer

of the option must pay a price at the start to the option seller.

This price is called the option premium or sometimes just the

option price.

Figure 1 Derivatives

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1.13 Indian Accounting Practices

Accounting for foreign exchange derivatives is guided byAccounting Standard 11. Accounting for Stock Index futures is

expected to be governed by a Guidance Note shortly expected tobe issued by the Institute of Chartered Accountants of India.

1.13.1 Foreign Exchange Forwards

An enterprise may enter into a forward exchange contract,or another financial instrument that is in substance a forwardexchange contract to establish the amount of the reportingcurrency required or available at the settlement date oftransaction. Accounting Standard 11 provides that the difference

between the forward rate and the exchange rate at the date ofthe transaction should be recognized as income or expense overthe life of the contract. Further the profit or loss arising oncancellation or renewal of a forward exchange contract should berecognized as income or as expense for the period.

AS-11 suggests that difference between the forward rate andExchange rate of the transaction should be recognized as incomeor expense over the life of the contract.

The Standard requires that the exchange difference betweenforward rate and spot rate on the date of forward contract beaccounted. As a result, the benefits or losses accruing due to theforward cover are not accounted.

AS-11 suggests that profit/loss arising on cancellation ofrenewal of a forward exchange should recognize as income or asexpense for the period.

1.13.2 Accounting of Index Futures

Internationally, fair value accounting plays an importantrole in accounting for investments and stock index futures. Fairvalue is the amount for which an asset could be exchangedbetween a knowledgeable, willing buyer and a knowledgeable,willing seller in an arms length transaction. Simply stated, fair

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value accounting requires that underlying securities andassociated derivative instruments be valued at market values atthe financial year end.

This practice is currently not recognized in India. AccountingStandard 13 provides that the current investments should becarried in the financial statements as lower of cost and fair valuedetermined either on an individual investment basis or bycategory of investment. Current investment is an investment thatis by its nature readily realizable and is intended to be held fornot more than one year from the date of investment. Anyreduction in the carrying amount and any reversals of suchreductions should be charged or credited to the profit and lossaccount.

On the disposal of an investment, the difference betweenthe carrying amount and net disposal proceeds should be chargedor credited to the profit and loss statement.

In countries where local accounting practices requirevaluation of underlying at fair value, size=2 index futures (andother derivative instruments) are also valued at fair value. Incountries where local accounting practices for the underlying arelargely dependent on cost (or lower of cost or fair value),accounting for derivatives follows a similar principle. In view ofIndian accounting practices currently not recognizing fair value, itis widely expected that stock index futures will also be accountedbased on prudent accounting conventions. The Institute isfinalizing a Guidance Note on this area, which is expected to beshortly released.

1.13.3 Regulatory Framework

The index futures market in India is regulated by the Reportsof the Dr L C Gupta Committee and the Prof J R VermaCommittee. Both the Bombay Stock Exchange and the NationalStock Exchange have set up independent derivatives segments,where select broker-members have been permitted to operate.These broker-members are required to satisfy net worth andother criteria as specified by the SEBI Committees.

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Each client who buys or sells stock index futures is firstrequired to deposit an Initial Margin. This margin is generally apercentage of the amount of exposure that the client takes upand varies from time to time based on the volatility levels in the

market. At the point of buying or selling index futures, thepayment made by the client towards Initial Margin would bereflected as an Asset in the Balance Sheet.

1.13.4 Daily Mark to Market

Stock index futures transactions are settled on a daily basis.Each evening, the closing price would be compared with theclosing price of the previous evening and profit or loss computedby the exchange. The exchange would collect or pay the

difference to the member-brokers on a daily basis. The brokercould further pay the difference to his clients on a daily basis.Alternatively, the broker could settle with the client on a weeklybasis (as daily fund movements could be difficult especially at theretail level).

1.13.5 Recognition of Profit or Loss

A basic issue which arises in the context of daily settlement

is whether profits and losses accrue from day to day or do theyaccrue only at the point of squaring up. It is widely believed thatdaily settlement does not mean daily squaring up. The dailysettlement system is an administrative mechanism whereby thestock exchanges maintain a healthy system of controls. From anaccounting perspective, profits or losses do not arise on a day today basis.

Thus, a profit or loss would arise at the point of squaring up.This profit or loss would be recognized in the Profit & Loss

Account of the period in which the squaring up takes place.

If a series of transactions were to take place and the client isunable to identify which particular transaction was squared up,the client could follow the First In First Out method of accounting.For example, if the October series of SENSEX futures waspurchased on 11th October and again on 12th October and sold

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on 16th October, it will be understood that the 11th Octoberpurchases are sold first. The FIFO would be applied independentlyfor each series for each stock index future. For example, ifNovember series of NIFTY are also purchased and sold, these

would be tracked separately and not mixed up with the Octoberseries of SENSEX.

1.13.5 Accounting at Financial Year End

In view of the underlying securities being valued at lower ofcost or market value, a similar principle would be applied to indexfutures also. Thus, losses if any would be recognized at the yearend, while unrealized profits would not be recognized.

A global system could be adopted whereby the client listsdown all his stock index futures contracts and compares the costwith the market values as at the financial year end. A total ofsuch profits and losses is struck. If the total is a profit, it is takenas a Current Liability. If the total is a loss, a relevant provisionwould be created in the Profit & Loss Account.

The actual profit or loss would occur in the next year at thepoint of squaring up of the transaction. This would be accountednet of the provision towards losses (if any) already effected in theprevious year at the time of closing of the accounts.

1.13.6 Accounting for Derivatives as per FAS 133

The standard requires that every derivative instrumentshould be recorded in the Balance Sheet as assets or liability atfair value and changes in fair value should be recognized in theyear in which it takes place.

The standard also calls for accounting the gains and lossesarising from derivatives contracts. It is important to understandthe purpose of the enterprise while entering into the transactionrelating to the derivative instrument. The derivative instrumentcould be used as a tool for hedging or could be a tradingtransaction unrelated to hedging. If it is not used as a hedging

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instrument, the gain or loss on the derivative instrument isrequired to be recognized as profit or loss in current earnings.

1.13.7 Derivatives used as hedging instruments

Derivative instruments used for hedging the fair value of arecognized asset or liability, are called Fair Value Hedges. Thegain or loss on such derivative instruments as well as theoffsetting loss or gain on the hedged item shall be recognizedcurrently in income.

1.13.8 Hedge Recognition

Accounting treatment for trading and hedging is completely

different. In order to qualify as a hedge transaction, the companyshould at the inception of the transaction:

Designate the hedge relationship Document such relationship

Identifying hedge item, hedge instrument and risks beinghedged

Expect hedge to be highly effective

Lay down reasonable basis for assessment effectiveness.Ineffectiveness may be reported in the current financialstatements earnings.

Earlier there was no concept of partial effectiveness ofhedge. However FASB recognized that not all hedgingtransactions can be perfect. There can be a degree ofineffectiveness which should be recognized. The Statementrequires that the assessment of effectiveness must be consistent

with risk management strategies documented for that particularhedge relationship. Further the assessment of effectiveness isrequired whenever financial statements or earnings are reported.

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1.14 Indian Market

The banking system in India has three tiers. These are the

scheduled commercial banks; the regional rural banks, which

operate in rural areas, not covered by the scheduled banks; and

the cooperative and special purpose rural banks.

There are approximately 80 scheduled commercial banks,

Indian and foreign; almost 200 regional rural banks; more than

350 central cooperative banks, 20 land development banks; and a

number of primary agricultural credit societies. In terms of

business, the public sector banks, namely the State Bank of India

and the nationalized banks, dominate the banking sector.

Scheduled commercial banks constitute those banks, which

have been included in the Second Schedule of the Reserve Bank

of India (RBI) Act, 1934. These banks enjoy certain privileges such

as free concessional remittances facilities and financial

accommodation from the RBI. They also have certain obligations

like minimum cash reserve ratio (CRR) to be kept with the RBI.

Some co-operative banks are scheduled commercial banks albeit

not all co-operative banks are.

At present the banking system can be classified into following

categories:

Public Sector Banks

Private Sector Banks

Co-Operative Sector Banks

Development BanksIndia's manufacturing sector is on an uptrend with the

majority of sectors recording positive trends in the first half of

fiscal year 2009-10, as compared with the corresponding period in

2008-09, according to a Confederation of Indian Industry (CII)

survey. The buoyant manufacturing growth in the first half is led

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by a rise in production of basic goods, intermediate goods and

consumer durables.

Quarterly estimate of GDP for April-June (Q1) 2009-10,

according to the Central Statistical Organization data, formanufacturing stood at US$ 40.85 billion at current prices.

According to data, the cumulative growth in the

manufacturing index for the period April to September 2009 as

compared to the same period last year has been 6.3 per cent.

The below extract from the speech of the Deputy Governor

shows the derivative transaction volumes taken by the Indian

MarketDerivative markets worldwide have witnessed explosive growth

in recent past. According to the BIS Triennial Central Bank Survey

of Foreign Exchange and Derivatives Market Activity as of April

2007 was released recently and the OTC derivatives segment, the

average daily turnover of interest rate and non-traditional foreign

exchange contracts increased by 71 % to $2.1 trillion in April

2007 over April 2004, maintaining an annual compound growth of

20 per cent witnessed since 1995. Turnover of foreign exchangeoptions and cross-currency swaps more than doubled to $0.3

trillion per day, thus outpacing the growth in 'traditional'

instruments such as spot trades, forwards or plain foreign

exchange swaps. The traditional instruments also show an

unprecedented rise in activity in traditional foreign exchange

markets compared to 2004. Average daily turnover rose to $3.2

trillion in April 2007, an increase of 71% at current exchange

rates and 65% at constant exchange rates. Relatively moderategrowth was recorded in the much larger interest rate segment,

where average daily turnover increased by 64 per cent to $1.7

trillion. While the dollar and euro clearly dominate activity in OTC

interest rate derivatives, their combined share has fallen by

nearly 10 percentage points since the 2004 survey, to 70 per cent

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in April 2007, as turnover growth in several non-core markets

outstripped that in the two leading currencies.

Indian Forex and derivative markets have also developed

significantly over the years. As per the BIS global survey thepercentage share of the rupee in total turnover covering all

currencies increased from 0.3 percent in 2004 to 0.7 percent in

2007. As per geographical distribution of foreign exchange

market turnover, the share of India at $34 billion per day

increased from 0.4 in 2004 to 0.9 percent in 2007. The activity in

the Forex derivative markets can also be assessed from the

positions outstanding in the books of the banking system. As of

August end, 2007, total Forex contracts outstanding in the banks'

balance sheet amounted to USD 1100 billion (Rs. 44 lakh crore),

of which almost 84% were forwards and rest options.

As regards interest rate derivatives, the inter-bank Rupee swap

market turnover, as reported on the CCIL platform, has averaged

around USD 4 billion (Rs. 16,000 crore) per day in notional terms.

The outstanding Rupee swap contracts in banks balance sheet,

as on August 31, 2007, amounted to nearly USD 1600 billion (Rs.

64,00,000 crore) in notional terms. Outstanding notional amountsin respect of cross currency interest rate swaps in the banks

books as on August 31, 2007, amounted to USD 57 billion (Rs.

2,24,000 crore).

The size of the Indian derivatives market is clearly evident from

the above data, though from global standards it is still in its

nascent stage. Broadly, Reserve Bank is empowered to regulate

the markets in interest rate derivatives, foreign currency

derivatives and credit derivatives. Until the amendment to the

RBI Act in 2006, there was some ambiguity in the legality of OTC

derivatives which were cash settled. This has now been

addressed through an amendment in the said Act in respect of

derivatives which fall under the regulatory purview of RBI (with

underlying as interest rate, foreign exchange rate, credit rating or

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credit index or price of securities) provided one of the parties to

the transaction is RBI, a scheduled bank or any other entity

regulated under the RBI Act, Banking Regulation Act or Foreign

Exchange Management Act (FEMA).

2.0 Review of Literature

In the literature on the competitive exporting firm under

exchange rate risk, it was typically assumed that the risk aversefirms makes its production and export decision prior to the

resolution of exchange rate uncertainty (e.g. Benninga et al 1985,

Kawai and Zilcha, 1986, Adam Muller 2000).In this case the firm is

inflexible since it cannot react on the realized exchange rate. Its

profits are linear in the exchange rate. Consequently, the

existence of futures contract is sufficient to derive a separation

theorem which states that firms production decision is

independent of its attitude towards risk and the exchange ratedistribution. In an unbiased future market, the firm completely

eliminates exchange rate risk by holding a full hedge position. As

shown by Lapan al (1991) and Batterman (2000), fairly priced

currency options play no role for an inflexible firm.

As per the paper The Effects of Derivatives on Firm Risk and

Value written by Sohnke M. Bartram, Gregory W. Brown, and

Jennifer Conrad although data on derivatives usage are more

widely available, the empirical evidence on the effects ofderivative use on firms risk and value is still mixed. Using a

sample of firms that initiate derivative use, Guay (1999) finds that

the total risk, idiosyncratic risk, and risk exposures to interest rate

changes of these firms decline, but he finds no significant change

in the market risk of these firms.

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In contrast, Hentschel and Kothari (2001) found that the

difference in risk for firms that use derivatives is economically

small compared to firms that do not use them. Allayannis and

Weston (2001) present evidence that hedging foreign currency

risk is associated with large (approximately 4%) increases inmarket value; Graham and Rogers (2002) found that hedging can

add an economically significant 1.1% to their market value by

allowing firms to increase their debt capacity. However, Guay and

Kothari (2003) showed that the magnitude of the cash flows

generated by hedge portfolios is modest and unlikely to account

for such large changes in value.

Consistent with this, Jin and Jorion (2006) used a sample of

oil and gas producers and find insignificant effects of hedging on

market value. Bartram and Brown in their paper on Derivatives

said that there is strong evidence that the use of financial

derivatives reduces both total risk and systematic risk. The effect

of derivative use on firm value was positive but more sensitive to

endogeneity and omitted variable concerns. However, hedging

with derivatives was associated with significantly higher value,

abnormal returns, and larger profits during the economic

downturn in 2001-2002, suggesting firms are hedging downside

risk. This might be because of a change in the (perceived) value

of risk management, with the value of firms that hedged

increasing during the economic decline. Alternatively, these

results simply reflect the unstable nature of the value results.

As per Modigliani and Miller (henceforth MM, 1958), a firm

managed by value maximizing agents, in a world of perfect

capital markets, with investors who have equal access to thesemarkets, would not engage in hedging activities since they add no

value. Anything the firm could accomplish through hedging could

equally well be accomplished by the investor acting on his or her

own account. If the perfect capital markets assumption is not met,

however, there may be rational reasons for the firm to hedge. The

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theoretical literature on hedging relaxes the MM assumptions and

develops specific reasons why individual firms may optimally

choose to hedge. As one might expect, these reasons tend to

involve either market frictions, such as taxes, transactions costs,

and informational asymmetries, or agency problems.

Smith and Stulz (1985) show that a convex tax function

implies that a firm can reduce expected tax liabilities by using

hedges to smooth taxable income. In addition, hedging may

increase a firms debt capacity, enabling it to add value by

increasing the value of the debt tax shield (Leland, 1998). Froot,

Scharfstein and Stein (1993) showed that managers facing

external financing costs may use hedging to reduce the

probability that internal cash flows are insufficient to cover

investments; Smith and Stulz (1985) show that hedging can

reduce expected costs of distress.

Empirical researchers have used data disclosed by firms to

examine the question of whether and how hedging affects the

risks of the firm. The evidence was mixed. Guay (1999)

investigates a sample of 234 U.S. non-financial firms that begin

using derivatives in the early 1990s and found that measures oftotal and idiosyncratic risk decline in the following year. He found

no significant evidence for changes in systematic risk.

Hentschel and Kothari (2001) examined the risk

characteristics of a panel of 425 large U.S. non-financial firms

from 1991 to 1993. Their results showed no significant

relationship between derivatives use and stock return volatility

even for firms with large derivatives positions.

The evidence for the effect of derivative use on market value

was also mixed. Allayannis and Weston (2001) found that firm

value (as measured by Tobins q) is higher for U.S. firms with

foreign exchange exposure that use foreign currency derivatives

to hedge.

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Brown and Conard conducted univariate results and found

that derivative use is more prevalent in firms with higher

exposures to interest rate risk, exchange rate risk and commodity

prices. Despite this, firms that used derivatives had lower

estimated values of both total and systematic risk, suggestingthat derivatives are used to hedge risk, rather than to speculate.

There are significant differences between derivative users

and non-users along other dimensions, emphasizing the

importance of multivariate tests. They employed three different

types of multivariate tests but concentrated on propensity score

matching, in which derivative users and non-users were matched

on the basis of their estimated propensity to use derivatives.

Compared to firms that do not use derivatives, they found that

hedging firms had lower cash flow volatility, idiosyncratic volatility

and systematic risk; these results were robust to a number of

different matching specifications, and the differences were both

statistically and economically significant. This suggests that

nonfinancial firms overall employ derivatives with the motive and

effect of risk reduction.

Consistent with the evidence in Allayannis and Weston(2001), derivative use is associated with a value premium,

although the statistical significance of this premium is weak.

These results suggest that the estimated effects of derivative use

on risk measures are robust. Even small differences in sample

construction, control variables and testing method could change

the estimated effect.

A 1995 survey of major non-financial firms revealed that at

least 70 percent were using some form of financial engineering tomanage interest rate, foreign exchange, or commodity price risk

(Wharton-Chase, 1995). Financial firms, including banks (Gunther

and Siems, 1995, and Shanker, 1996), savings and loans (Brewer,

et al., 1996), and insurers (Colquitt and Hoyt, 1997, Cummins,

Phillips, and Smith, 1997), also were active in derivatives

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markets. Although the types of risks confronting managers vary

across industries, there was substantial commonality in the

underlying rationale for the use of derivatives and the financial

engineering techniques that were employed.

Cummins, Phillips, and Smith (CPS) (1997) presented

extensive descriptive statistics on the use of derivatives by U.S.

life and property-liability insurers and conducted a probit analysis

of the participation decision. Colquitt and Hoyt (CH) (1997)

analyzed the participation and volume decisions for life insurers

licensed in Georgia.

The paper Derivatives and Corporate Risk Management:

Participation and Volume Decisions in the Insurance Industry byDavid Cummins suggests the following regarding the usage of

derivatives in Insurance Industry.

In this paper, they formulated and tested a number of

hypotheses regarding insurer participation and volume decisions

in derivatives markets. We base our hypotheses on the financial

theories of corporate risk management that have developed over

the past several years. The two primary, and non-mutually

exclusive, strands of the theoretical literature held that

corporations were motivated to hedge in order to increase the

welfare of shareholders and/or managers. Their results provided a

considerable amount of support for the hypothesis that insurers

hedge to maximize value. Several specific hypotheses were

supported by their analysis.

In terms of participation in derivatives markets, they found

evidence that insurers were motivated to use financial derivativesto reduce the expected costs of financial distress the decision

to use derivatives was inversely related to the capital-to-asset

ratio for both life and property-liability insurers. They also found

evidence that insurers use derivatives to edge asset volatility,

liquidity, and exchange rate risks. Life insurers appeared to use

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derivatives to manage interest rate risk and the risk from

embedded options present in their individual life insurance and

GIC liabilities.

There was also some evidence that tax considerations play arole in motivating derivatives market participation decisions by

insurers. Finally, they provided support for the hypothesis that

there were significant economies of scale in running derivatives

operations. Thus, only large firms and/or those with higher than

average risk exposure would find it worthwhile to pay the fixed

cost of setting up a derivatives operation. Interestingly, however,

they found that, conditional on being a user of derivatives, the

relationship between the volume of derivatives activities and

these same risk measures often displayed exactly the opposite

result to those found in the participation regression.

Their analysis provided only weak support for the utility

maximization hypothesis. The only variable that carried

significant implications regarding utility maximization was the

ratio of surplus notes to assets, which was positively but weakly,

related to both the participation and volume decisions for

property-liability insurers.

3.0 Data and Methodology

3.1 Data

The data come from Schedules and Notes to Accounts and

Managerial Discussion of the 2009 Annual statements released by

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Banks (ICICI and Indian Bank) and Manufacturing Companies

(Hindalco and Tata Iron and Steel Company).

Data list for banks has been grouped under different heads

for analysis. The groups are Hedging Transaction

Trading Transaction

It also gives details about the Notional Amount involved in

the Derivative Transactions. It also shows about the mark to

market value of the assets and liabilities that arise because of the

derivative transaction.

It also contains the details about the FRA and Interest Rate

Swap Agreements taken by the bank during the last financial

year. The relevant table also contains the details about the

collateral required for entering into those transactions.

It also speaks about the split of domestic and foreign

exposure taken by the bank and the capital requirement for

different kind of risks taken by the bank during the last financial

year.

Banks primary Income is influenced by interest rates as its

assets consists of domestic loans and foreign currency loans.

Impact of interest rate in each of these currencies has an impact

on the net interest income of the bank. This effect is also provided

in the data set collected for the purpose of evaluating Translation

Risk.

For the data pertaining to manufacturing sector the samplesthat were considered were Hindalco and that of Tata Iron and

Steel Company.

The data shows the export contracts that these companies

had during the last financial year. It also speaks about Buyers

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Credit, imports and foreign currency earnings made by the

organization.

Data set also contains the Foreign Currency Exposure that is

not hedged by derivative instruments. It also contains the detailsabout the various derivative contracts entered by the company

for hedging foreign currency exposures which includes

commodity.

One of the tables shows the split of the income the company

makes from domestic market and foreign market. Details also

include the extent to which raw materials are imported for the

production and operation of the company.

3.2 Methodology

VaR method of calculation is used to calculate the risk

involved in the transaction and suitable derivative instrument of

relevant value is used.

VaR defines the loss in market value of say, a portfolio, over

the time horizon T that is exceeded with probability 1 PVaR. In

other words, it is the probability that returns (losses), say , are

smaller than VaR over a period of time (horizon) T , or:

where PT () is the probability distribution of returns over the

time period (0, T ).

Monte Carlo Simulation method of calculating VaR will be

used. MS Excel addin will be the software used for calculation

using this method.

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Hypothetical value will be assumed for minimum and

maximum value for each of the transaction that a company (Bank

and Manufacturing) undergoes where minimum and maximum

value will be based on the value obtained from the data collected.

Hypothetical sample size will be assumed which is one of the

constraints in the calculation of VaR The scenario will be

simulated for different confidence level and VaR of each

hypothetical transaction will be arrived.

The simulated values form a probability distribution for the

value of a portfolio which is used in deriving the VaR figures. By

using Monte Carlo techniques one can overcome approaches

based solely on a Normal underlying distribution.

Based on the nature of the transaction and VaR arrived

suitable derivative instrument is opted. The value of the

derivative contract is determined based on the nature of the

instrument, expiry of the instrument and VaR arrived earlier.

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4.0 Analysis and Interpretation

4.1 Manufacturing Industry

Hindalco and JSW Steel were the companies that were

considered for deriving the base value for the hypotheticalsituations.

4.1.1 Buyers Credit

Buyers Credit is the credit availed by an importer from the

overseas lender. Manufacturing industries avail these options for

purchasing raw materials etcIn this case Hindalco has taken

buyers credit on an average of 48.525 million USD with a

standard deviation of 21.95 million USD.

By running Monte Carlo Simulation and converting the input

sample as a normal function with mean of 48.525 and standard

deviation of 21.95 for sample of 30, 0000 VaR is arrived. This

method is Variance-Covariance Approach as the mean and

standard deviation is determined based on historical value.

The Exchange rates that have been used in the conversion

are also converted as normal distribution for arriving at IndianRupee. The mean so obtained from last one year data was 48.339

INR and standard deviation so obtained was INR 1.4922

VaR so obtained with 99% confidence level with right tail

suggests that there is a 1% probability that credit value will go

above 99.512 million USD.

Below figures show the normal distribution of input data i.e.

Exchange Rate and Credit Values.

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Figure 2 Buyers Credit MTM

Figure 3 Buyers Credit

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Figure 4 Exchange Rate Probability

Buyers Credit(million

USD)

Exchange Rate

Mean 48.525 48.33938821

SD 21.95566556 1.49223283

Table 1 Buyers Credit

Buyers Credit(

million USD)

Buyers Credit

MTM(INR Crores)

VaR 99.55124051 4828.304403

Buyers Credit Present

Value

64.05 2995.727385

Table 2 Buyers Credit VaR

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Company could hedge itself by entering into Forex Forwards

for the credit taken at the specified Exchange rate. But these

contracts have counter party risk.

It can also hedge its position using Currency Futures.Company should enter into currency futures by buying dollars at

the desired risk level. This hedge comes with a cost of initial

margin. If not the company should be prepared to VaR level at the

worst case scenario.

Instrument Disadvantage

Forex Forwards Counter Party Risk

Currency Futures Initial Margin

Table 3 Buyers Credit and Derivative Instruments to be

used

4.1.2 Commodities Contract (Gain/Loss)

Manufacturing companies enter into these types of contracts

to hedge their position against commodity price risk which theymight face because of uncertain conditions. Hindalco on an

average has 24.44 Crores in INR with a standard deviation of INR

12 Crores.

Monte Carlo simulation is executed with these mean values

and standard deviation was decided using variance method. Input

is varied as normal distribution using random number generation

and VaR is calculated as INR 3.561 Crores.

Company could hedge its position using Commodity Futures

and Forward Contracts.

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Figure 5 Commodities Contract

Commodities(INR Crores)

Mean 24.44

SD 12

Table 4 Commodities Contract

Commodities(INR

Crores)

VaR -3.56561

Table 5 Commodities Contract VaR

Company should be ready to face a loss of INR 3.56561Crores in its worst case.

Commodity Contracts are also entered in foreign Currency

for which hedging has to be done with currency futures along with

Commodity Futures to hedge the position.

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Monte Carlo Simulation is run with exchange rates being

normally distributed along with the mean commodity contracts

entered into in the foreign currency.It has to be noted that

company has been incurring loss on these type of contracts based

on historical data which is reflected in its mean data.

Contracts which are taken for hedge should theoretically

result in no loss or no gain position. But these contracts which

have been taken is consistently showing loss which shows the

uncertainity in the commodity price movements in foreign market

or it could be the wrong positions taken by the companies.

The below graph shows the Commodities Contract MTM

values in INR (millions) which is obtained by simulating theexchange rate which is also assumed to be distributed normally.

Figure 6 Commodities Contract MTM

The below graph is obtained by considering the gain/loss

value of the contracts in USD and is normalized based on the

mean value which is obtained based on historic data.This graph

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doesnt consider the exchange rate fluctuation which was

considered in the earlier case.

Figure 7 Commodities Contract

Figure 8 Exchange Rate

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VaR obtained by considering the transaction in USD is found to be

-11.701 million USD which is approximately INR 565.65 million

while the VaR obtained by considering normal distribution of

exchange rates comes to be INR 566.753 million. Variation is little

because of lesser fluctuation in exchange rates which could beconsiderable if a volatile currency is considered.

4.1.3 Export Earnings

These manufacturing companies export their finished goods

to different countries and expect their payment at future date.

Mean value of export earnings made by the company iscalculated using co variance approach and arrived as INR 5148.18

Crore and standard deviation of INR 2500 Crore.

Figure 9 Export Earnings

Monte Carlo Simulation when run based on these data

showed VaR loss of INR 582.2 Crores. This shows that company

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has to prepare itself for loss accounting 582.2 Crores which has

the probability of occurrence of 1%.

Company could hedge its earning by entering into Forward

Contracts and by selling Currency Futures.

Export Earnings(INR

Crores)

Mean 5148.18

SD 2500

Table 6 Export Earnings

Export Earnings(INR

Crores)

VaR -582.2

Table 7 Export Earnings VaR

Exchange rate fluctuation is not considered for analysis because

of lack of availability of data in each currency.

Instrument Disadvantage

Forex Forwards Counter Party Risk

Forex Futures Initial Margin

Table 8 Export Earnings and Derivative Instruments to be

used

4.1.4 Investments

Manufacturing Companies invest their excess cash at

different investment centers to make effective use of them. There

is a greater possibility that companies could benefit out of it. If

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the company has taken wrong decision or invested in poor

performing sector it is bound to erode its investment value.

Mean of investment value made by Hindalco is arrived using

historical covariance approach as INR 492.755 Crores with astandard deviation of INR 41.755 Crores.

When Monte Carlo Simulation is run based on these values

with normal distribution as Input variations VaR at 99%

confidence level arrived to be INR 396.7425 Crores which means

there is a probability of 1% that the investment made could fall

below this value.

Company should hedge its position by investing inderivatives thereby preventing the erosion of the investment

value. Kind of derivative instruments that the company should

enter in highly depends on the type of investment that the

company has made. If the company has invested in foreign

companies it should hedge its position using currency futures and

options. If on the other hand if the investment is bound to

fluctuate based on the interest rate variations then it should

hedge itself by opting for Interest Rate Futures and Interest Rate

options.

Company should opt for Option contracts if the company has

more positive view on the investment growth features. Option

Contracts are generally used as hedge instruments to protect

itself from adverse movements and these option contracts should

be at the VaR level to avoid further erosion.

Below graph shows the normal distribution of the investment

value with mean and standard deviation arrived using covariance

method.

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Figure 10 Investment Value

Investment Value (INR

Crores)

Mean 492.755

SD 41.755

Table 9 Investments

Investment Value

(INR Crores)

VaR 396.7425

Table 10 Investments VaR

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Instrument Scenario

Forex Futures Investments are in Foreign

Currency

Interest Rate Futures Investments vulnerable with

adverse interest rate

movements

Option Contracts To serve as insurance at

adverse movements

Table 11 Investments and Derivative Instruments to be

used

4.2 Banking Sector

Banking industries use derivative instruments to hedge its

position against different exposures it has taken in its business

activity. Banks that have been considered for arriving at the base

values for the simulation are ICICI and Indian Bank.

Some of the transactions that are taken by the banks are listed

below.

4.2.1 Forex Transactions

Forex Transactions that have been entered by the banks

could be in different currencies. Because of the constraint in

availability of individual split up in each currency the Forex

Transaction value in denomination of USD, which is converted in

INR, is taken into consideration for analysis.

Based on historical variance approach mean of Forex

Transaction Profit /Loss that the bank makes in its Forex

Transaction is arrived to be INR 592.935 million with a standard

deviation of INR 719.5328 Crores.

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Figure 11 Forex Transaction Profit/Loss

Forex Transactions

(Million INR)

Mean 592.9325

SD 719.5328

Table 12 Forex Transactions

Forex Transactions

(Million INR)

VaR -1080.97

Table 13 Forex Transactions VaR

Instrument Scenario

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Currency

Interest Rate Futures Investments vulnerable withadverse interest rate

movements


adverse movements

Table 14 Forex Transactions and Derivative Instruments to

be used

4.2.2 Currency Swaps

Currency Swaps are the transactions that banks make to

warehouse its position at different currency exposures and also as

trading instruments for profit making.

Mean Value of Swap value made by the bank on these

transactions arrived to be INR 523.3435 million with a standard

deviation of INR 65.48445 million.

VaR arrived based on these values for the above transaction

using normal distribution arrived to be INR 674.6693 million at

99% confidence level.



method.

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Figure 12 Currency Swaps

Currency

Swaps(Million INR)

Mean 523.3435

SD 65.48445

Table 15 Currency Swaps

Currency

Swaps(Million INR)VaR 674.6693

Table 16 Currency Swaps VaR

This VaR value is necessary in calculation of ALM in banks.

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4.2.3 Investments

Banks invest their excess cash at different investment

centers to make effective use of them. There is a greater

possibility that companies could benefit out of it. If the company

has taken wrong decision or invested in poor performing sector it

is bound to erode its investment value.

Mean of investment value made by ICICI is arrived using

historical covariance approach as INR 1072.563 million with a

standard deviation of INR 59.36869 Crores.

When Monte Carlo Simulation is run based on these values

with normal distribution as Input variations VaR at 99%

confidence level arrived to be INR 396.7425 Crores which meansthere is a probability of 1% that the investment made could fall

below this value.

Company should hedge its position by investing in

derivatives thereby preventing the erosion of the investment

value. Kind of derivative instruments that the company should

enter in highly depends on the type of investment that the

company has made. If the company has invested in foreigncompanies it should hedge its position using currency futures and

options. If on the other hand if the investment is bound to

fluctuate based on the interest rate variations then it should

hedge itself by opting for Interest Rate Futures and Interest Rate

options.

Company should opt for Option contracts if the company has

more positive view on the investment growth features. Option

Contracts are generally used as hedge instruments to protectitself from adverse movements and these option contracts should

be at the VaR level to avoid further erosion.

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method.

Figure 13 Investments Outside India

Investments (outside India)

(Million INR)

Mean 1072.563

SD 59.36869

Table 17 Investments Outside India

Investments (outside India)

(Million INR)

VaR 933.4768

Table 18 Investments Outside India VaR

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Instrument Scenario


Currency

Interest Rate Futures Investments vulnerable with


movements


adverse movements

Table 19 Derivative Instruments for Investment Outside

India Transactions

4.2.4 Borrowings

Borrowings made by the banks in terms of ECB and otherforeign currency loans come under this head. These values are

highly impacted by change in Exchange Rates and interest rate

fluctuations which could add up to the interest rate burden and

also in terms of redemption.

When these rates go in adverse direction could impact the

interest paid by the banks and reduce the profit levels.

With mean value of INR 703.938 million and standarddeviation of INR 141.995 million Monte Carlo simulations run on

these parameters produced a VaR of INR 1029.978 million at 99%

confidence level. This implies that there is 1 % probability that

borrowings could increase above INR 1029.978 million.

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The derivative instruments that could be used are series of

FRAs and Interest Rate Swaps. These instruments would help the

borrower in raising Interest rate scenarios.

Below graph shows the normal distribution of the investmentvalue with mean and standard deviation arrived at using

covariance method.

Figure 14 Borrowings Outside India

Borrowings (outside India)

(Million INR)

Mean 703.938SD 141.9955

Table 20 Borrowings

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Borrowings (outside India)

(Million INR)

VaR 1029.978

Table 21 Borrowings VaR

Instrument Scenario

FRA Likely change in interest ratescenario

Interest Rate Futures Borrowings vulnerable with


movements

Option Contracts Cap contracts when there is a

likely increase in interest rate

Table 22 Derivative Instruments for Borrowings Made

4.2.5 Deposits

These are the deposits made by the retail investors with the

bank. These are the source of fund for the banks. Fluctuation of

these deposits indicates the fluctuation in source of money for the

bank.

Mean of the Deposits held by the bank is arrived as INR

88.586 Crores with a standard deviation of INR 23.354 Crores.

VaR so generated out of this method suggests that there is a 1%

probability of deposits running lower to INR 34.527 Crores and

below.

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Bank should take up necessary measure to ensure the

liquidity problem that might occur because of this adverse effect

to be mitigated or reduced. If the banks deposit level reaches this

level along with other cash outflows or business requirements

remaining constant it should look for other sources of generatingincome.

If the fluctuation in deposit is mainly due to FCNRB Deposits

then bank should make necessary provisions to handle this

liquidity problem.


value with mean and standard deviation arrived at using

covariance method.

Figure 15 Deposits

Deposits (outside India)

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(Crores INR)

Mean 88.586

SD 23.35574

Table 23 Deposits

Deposits (outside India)

(Crores INR)

VaR 34.57277

Table 24 Deposits VaR

4.2.6 Credit Exposure Overseas

Credit Exposures are the exposures that bank has taken in

overseas market. These are classified under two heads Fund

Based and Non Fund Based. Fund Based exposures are where the

banks have paid in cash in behalf of client which implies cash has

left the system e.g. of Fund based exposure are Cash Credit and

Term loans. Non Fund Based exposures are where the banks are

liable to pay in case of default made by the client e.g. of NonFund Based Exposure are Bank Guarantee and Packing Credit.

Mean value of Fund based exposure taken by the bank

arrived using historical covariance approach are shown below and

the values are INR 874.32 Crores with standard deviation of INR

103.91 Crores. Monte Carlo Simulation when run based on these

values produced a VaR of INR 627.59 which implies that there is

one percent probability that credit exposure could fall to such low

value and below that.

Company could hedge its position using Credit Default

Swaps with other banks or other financial institutions to hold its

position at the worst case.

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Mean value of Non-Fund based exposure taken by the bank




values produced a VaR of INR -105.32 which implies that there isone percent probability that credit exposure could fall to such low




position at the worst case. On Fund Based Credit Exposure are

source of high income for the banks as they dont have charge on

the capital.

Figure 16 Credit Exposures (Overseas) - Fund Based

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Figure 17 Credit Exposures (Overseas) - Non Fund Based

Fund Based (CroresINR)

Non Fund Based(Crores INR)

Mean 874.32 169.72

SD 103.91 118.9

Table 25 Credit Exposure- Overseas Transactions

Fund Based (INR) Non Fund Based(Crores INR)

VaR 627.5952 -105.321

Table 26 Credit Exposure-Overseas Transactions VaR

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Instrument Scenario

Credit Swaps When Credit Rating of the assets

are poor

Forex Futures To avoid Translation Risk

Table 27 Derivative Instruments for Credit Exposure-

Overseas Transactions

4.2.7 Credit Exposure Domestic

This is similar to Credit Exposure in Overseas Market except

for the absence of Translation risk.Mean value of Fund based exposure taken by the bank




values produced a VaR of INR 2552.981 which implies that there

is one percent probability that credit exposure could fall to such

low value and below that.



position at the worst case.

Mean value of Non-Fund based exposure taken by the bank




values produced a VaR of INR 737.595 which implies that there isone percent probability that credit exposure could fall to such low




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position at the worst case. On Fund Based Credit Exposure are

source of high income for the banks as they dont have charge on

the capital.

Figure 18 Credit Exposures (Domestic) - Fund Based

Figure 19 Credit Exposures (Domestic)- Non Fund Based

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Fund Based

(Crores INR)

Non Fund Based

(Crores INR)

Mean 2663.09 1478.532

SD 47.22 321.038

Table 28 Credit Exposure Domestic

Fund Based (Crores

INR)

Non Fund Based

(Crores INR)

VaR 2552.981 737.595

Table 29 Credit Exposure Domestic VaR

4.2.7 Currency Derivatives

These are the existing instruments with the bank. Notional

Principal amount is just the indication of risk that bank will get

exposed to if it goes in the worst case.

Notional Principal MTM value suggests that there is a 1%

probability of this value going below USD 8.0258 million.Similarly MTM Value of Notional Principal Amount on Trading

Exposures has 1% probability of going below USD -862.577

million. Banks use this value in calculation of risk parameters in

BASEL II norms. Mean and Standard Deviation are arrived using

Covariance method.

60


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Figure 20 Currency Derivatives Notional Principal Amount

- Hedging MTM

Figure 21 Currency Derivatives Notional Principal Amount

- Trading MTM

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Figure 22 Exchange Rate

NotionalPrincipal

Amount-

Hedging

(Million USD)

NotionalPrincipal

Amount-

Trading

(Million USD)

ExchangeRate

Mean 0.498072 28.30608 48.33939

SD 3.718675 378.2576 1.492233

Table 30 Currency Derivatives

Notional Principal

Amount - Hedging(Million

USD)

Notional

Principal

Amount -

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Trading (Million

USD)

VaR -8.02518 -862.577

Table 31 Currency Derivatives VaR

4.2.8 Interest Rate Derivative Assets

These are the interest rate derivative assets that the bank

holds. The probability of these assets falling below INR 3770.23

Crores is

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Derivatives as Risk Management Tool for Corporates

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